Borrowed reserves: Politics or Economics?

This post was necessitated by two things. Firstly, the recent Currency Swap Agreements between the Central Bank of Sri Lanka (CBSL) and the Reserve Bank of India (RBI). Secondly, the recent upheavals in the political environment and the lack of clarity on how such swaps help the economy plus the mechanics. In fact, it is my understanding that the current political developments pushed the existing government to show that their economic management is better than the previous regime and hence there is no pressure on the LKR or the reserve position (as the opposition alleged).  

Some background

Central Bank currency/liquidityswaps are not new to the financial world. They are mostly used during crises. As per this Zerohedge article, China has become a prominent player in the currency swap market since of late.

In the South Asian region, India was utilizing the Swap arrangements with Bank of Japan (BoJ). Further, in May 2012 at the SAARCFINANCE governors’ meeting it was announced that RBI has offered a swap arrangement of up to USD2 billion both in foreign currency (USD and EUR) and Indian Rupees (INR) with a view to strengthening regional financial and economic cooperation. This facility is intended to be used to meet any balance of payments and liquidity crises till longer term arrangements are made or if there is need for short-term liquidity due to market turbulence. The very first swap under this agreement was signed in March 2013 between the RoyalMonetary Authority of Bhutan and RBI for a value of USD100 million.

Mechanics of the RBI arrangement

Under this agreement, RBI will offer USD, EURO or INR against the requesting country’s domestic currency or domestic currency denominated government securities. India is contributing USD 2 billion towards this. Any country (specified SAARC countries only) can draw subject to a minimum of USD 100 million and a maximum of USD400 million. Drawals can be made in multiple tranches. Each such drawal will be of 3 month tenor (with possibility to extend on maturity with the second rollover at a higher interest rate, i.e., 50 bps more than the normal rate). The normal interest here is 3m LIBOR+200 bps or RBI Repo Rate-200 bps on INR drawal. (Currently RBI Repo Rate is at 7.25%). From this it is obvious that this is no different to borrowing offshore. Only difference is that you don’t call it a borrowing rather a currency swap (which is difficult to understand!)    

   

CBSL’s signing of the bilateral swap agreements with RBI

In March this year, CBSL signed the Currency Swap Agreement with the RBI and the agreement is valid for a period of three years. (Expires on March 2018). Within this period, CBSL can draw up to USD400 million (or equivalent) in multiple tranches. (under above mentioned terms, of course) This I believe is an indication that there is a balance of payment or liquidity crises. (or is expected). This belief is further reinforced as the CBSL signed a Special Currency Swap Agreement in July 2015 for a value of up to USD1.1 billion for a period of 6 months. This special facility proposal of USD1.1 billion was approved by the Union Government of India. (So we can’t say it is not political). Plus during that period, the government of Sri Lanka was on the verge of announcing a general election. Hence, the ruling government would not want to let a currency related matter to disadvantage them in the forthcoming elections. (I assume and this is again politics!) I believe that they can show a higher reserve amount (taking in to account the drawing rights) and show that they were not borrowing (at least to the general person, as they were vehement against foreign borrowing by the previous regime) as the name hides the fact this itself is borrowed reserves.

As far as information is concerned, CBSL has not done any drawals so far. (My understanding). If CBSL did not make a drawing, it won’t affect unless there is some fees involved on undrawn amounts. (There is no such fees). 

  

Bottomline

Currency Swaps are good instruments to deal with short term currency crises and hence it is perfectly normal to tap that source. However, it is not a long term mechanism to cover up bad policy. Hence, these measures should be followed by more permanent long-term measures to deal with reserve management of the country. Or else the country will be deep in a vicious cycle.  

End of the day politics and economics go hand in hand.